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Our goal is to determine the market value of the derivative transaction of interest, in this case, swaps. At the start of a swap, the market value is set to zero.
The process of pricing the swap involves finding the terms that force that market value to zero. To determine the market value of a swap, we replicate the swap using other instruments that produce the same cash flows. Knowing the values of these other instruments, we are able to value the swap. This value can be thought of as what the swap is worth if we were to sell it to someone else. In addition, we can think of the value as what we might assign to it on our balance sheet. The swap can have a positive value, making it an asset, or a negative value, making it a liability.
Swaps are equivalent to a variety of instruments, but we prefer to use the simplest instruments to replicate the swap. The simplest instruments are the underlying assets: bonds, stocks, and currencies. Therefore, we shall use these underlying instruments to replicate the swap.
To understand the pricing of currency, interest rate, and equity swaps, we shall have to first take a brief digression to examine an instrument that plays an important role in their pricing. We shall see that the floating-rate security will have a value of 1.0, its par, at the start and on any coupon reset date. Recall that we have made numerous references to floating rates and floating payments. Accordingly, we must first obtain a solid understanding of floating-rate notes.